Saturday, February 04, 2006

The Greenspan era ended peacefully. I somehow expected that colors would look
a bit dull, or the chirping of birds would become melancholy. Things instead
seemed pretty much unchanged – we slid into the Bernanke era with an FOMC
statement that contained little new information. We need to assume policy
continuity until the new top dog says otherwise. In my mind, I think Fed policy
is running on two competing planks:

With a full 350bp of tightening in the pipeline, and some indications of
softening in housing, Fed officials would like the opportunity to pause to
assess their handiwork.

Increases in resource utilization and the omnipresent threat of
higher energy price leave policymaker’s uneasy about pausing at this
point.

The term “conundrum” comes to mind. My bet is that plank number 2 will be the
winner – the solid economic data with the continuous threat of inflation
suggests the Fed will still draw another arrow from its quiver.

Last week I said the Fed would not take
such a dim view of the Q4 GDP report in light of anecdotal evidence and the
higher frequency data. The statement of
last week’s FOMC meeting conforms to
this view:

Although recent economic data have been uneven, the expansion in economic
activity appears solid.

The “uneven” data is likely a reference to the weak GDP report. Still, the
Fed did not seem as concerned about the uptick in core-PCE as I thought:

Nevertheless, possible increases in resource utilization as well as
elevated energy prices have the potential to add to inflation pressures.

The Committee judges that some further policy firming may be needed to keep
the risks to the attainment of both sustainable economic growth and price
stability roughly in balance.

As
others have noted, the shift in language
was expected and provides maximum flexibility for Bernanke & Co. to maneuver.
The identification of resource utilization rates (see my
Fed watch two weeks ago) and energy
costs indicates the bias is to tighten further, in my view. The “may be needed”
phrases indicates, however, that no tightening is guaranteed. The Fed did not
send up an all’s clear signal. Instead, we need to shift through two months of
data to determine the degree of resource utilization. And the tone of recent
data suggests the Fed will tighten yet again when Bernanke presides over his
first FOMC meeting as chairman and the end of March.

The January employment report adds another piece of evidence in favor of
additional tightening. True, it was not a blockbuster report. Instead, it
suggested a certain continuity – the slow gradual tightening of the labor
market. Employers added just under 200k workers to the payrolls with gains well
spread throughout the economy. The weak spot was retailing, and construction was
an unexpected strong point considering evidence of softening in that sector.
Recent months were revised higher as well.

The unemployment rate fell to 4.7%, a low enough number that some FOMC
members will be getting increasingly nervous about “resource utilization.” Some
will point to the slight uptick in the employment to population and low labor
force participation rates as evidence that the labor market is weak. I think
that is a difficult argument to make – see also
David Altig’s thoughts on this point.
There are likely secular trends in the labor markets that are not fully
accounted for yet. Another potential weak spot in the report was the flat work
week.

Overall, however, my take on the data suggests a relatively strong labor
market. In addition to steady job growth and low unemployment, wages gains are
accelerating, with January’s 7 cent gain pushing wages up 3.3% compared to last
year (and 2 consecutive 0.4% monthly gains, or an annualized 5.3% gain in
January). And buried within the data are further bright spots, such as a solid
decline in long term unemployment (more than 27 weeks):

Also, the unemployment rate including marginally attached persons and those
employed part time for economic reasons continued its steady march down as well:

Now, one does have to be careful with unemployment rates as they are lagging
indicators. But initial jobless claims – a leading indicator – remain low (in
Oregon claims have dropped to the lowest level in over 10 years). Moreover, I am
picking up anecdotal evidence that employers are sensing a change as well.
Paraphrasing one employer, “My employees are asking for higher wages, and
actually expecting they will get them. And they do.”

When employers complain about lack of potential workers, I tell them they
need to raise wages. This doesn’t make them happy, either.

Note that I am not attributing a stronger labor market to any specific
economic policies. And it is true that the labor market remained lackluster for
an extended period of time. But it does look like conditions have significantly
improved over the past year, and the Fed will take note. For a different view,
and another potential measurement problem, changes in the rates of
non-responders, see
Dean Baker at MaxSpeak.

In addition to the employment report, the bulk of this week’s data has also
been supportive of another rate hike. Productivity growth stumbled (see
David Altig) and unit labor costs
gained. I would be somewhat careful about overreacting to this report. The Q4
GDP report looked weak due to a number of factors that all came together at
once, but are probably not indicative of the underlying economic trend. This
would of course also apply to the productivity numbers. Still, the best days of
high productivity growth look behind us. The Fed will be wary that firms are
having an increasingly difficult time improving productivity, providing
additional incentive to push higher costs down the line.

The Institute of Supply
Management also provided its snapshot of manufacturing and non
manufacturing activity. In both cases, the outcome was slightly weaker than
expectations, but still suggestive that the economy remains on solid footing.
The details of the manufacturing report suggested the “resource utilization” in
growing – inventories were contracting, customer’s inventories were too low,
prices paid edged up, and the backlog of orders continued to grow. More meat to
feed the inflation hawks at the FOMC. But perhaps they will be softened somewhat
by the non manufacturing report, which indicated that inventories were too high.
Calculated Risk provides his thoughts and points out the
discontinuity of reports of a contracting construction industry with the
expansion in employment in that industry.

Two weeks ago I said that barring any
significant shifts in the bond markets, the Fed was ready to pull the trigger on
a complete inversion of the yield curve when policymaker’s pushed the overnight
rate to 4.5%. Since then, bonds have fallen substantially, with the 10 year rate
currently hovering around 4.55% (the curve is inverted at the 10 year – 2 year
horizon). A slim margin, to be sure, but a margin nonetheless.

Will longer term interest rates move up again? Or will the negative factors
waiting on the sidelines – the lagged impact of previous rate hikes, a softening
housing market, low saving rates, and possible consumer fatigue – turn against
us and put the FOMC firmly into pause mode? Many, I think would prefer to see
the Fed wait it out a meeting or two – see
Jim Hamilton, for instance. But the
steady, mostly supportive flow of data suggests not just yet, with the odds
still on the Fed will raise rates to 4.75% on March 28th.

Still, two months of data is a lot to chew on, and it is likely we will all
be scratching our heads between now and then. [All
Fed Watch posts.]

Comments

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Fed Watch: Placing Bets on Bernanke’s First Move

Tim Duy's Fed Watch:

The Greenspan era ended peacefully. I somehow expected that colors would look
a bit dull, or the chirping of birds would become melancholy. Things instead
seemed pretty much unchanged – we slid into the Bernanke era with an FOMC
statement that contained little new information. We need to assume policy
continuity until the new top dog says otherwise. In my mind, I think Fed policy
is running on two competing planks:

With a full 350bp of tightening in the pipeline, and some indications of
softening in housing, Fed officials would like the opportunity to pause to
assess their handiwork.

Increases in resource utilization and the omnipresent threat of
higher energy price leave policymaker’s uneasy about pausing at this
point.

The term “conundrum” comes to mind. My bet is that plank number 2 will be the
winner – the solid economic data with the continuous threat of inflation
suggests the Fed will still draw another arrow from its quiver.

Last week I said the Fed would not take
such a dim view of the Q4 GDP report in light of anecdotal evidence and the
higher frequency data. The statement of
last week’s FOMC meeting conforms to
this view:

Although recent economic data have been uneven, the expansion in economic
activity appears solid.

The “uneven” data is likely a reference to the weak GDP report. Still, the
Fed did not seem as concerned about the uptick in core-PCE as I thought:

Nevertheless, possible increases in resource utilization as well as
elevated energy prices have the potential to add to inflation pressures.

The Committee judges that some further policy firming may be needed to keep
the risks to the attainment of both sustainable economic growth and price
stability roughly in balance.

As
others have noted, the shift in language
was expected and provides maximum flexibility for Bernanke & Co. to maneuver.
The identification of resource utilization rates (see my
Fed watch two weeks ago) and energy
costs indicates the bias is to tighten further, in my view. The “may be needed”
phrases indicates, however, that no tightening is guaranteed. The Fed did not
send up an all’s clear signal. Instead, we need to shift through two months of
data to determine the degree of resource utilization. And the tone of recent
data suggests the Fed will tighten yet again when Bernanke presides over his
first FOMC meeting as chairman and the end of March.

The January employment report adds another piece of evidence in favor of
additional tightening. True, it was not a blockbuster report. Instead, it
suggested a certain continuity – the slow gradual tightening of the labor
market. Employers added just under 200k workers to the payrolls with gains well
spread throughout the economy. The weak spot was retailing, and construction was
an unexpected strong point considering evidence of softening in that sector.
Recent months were revised higher as well.

The unemployment rate fell to 4.7%, a low enough number that some FOMC
members will be getting increasingly nervous about “resource utilization.” Some
will point to the slight uptick in the employment to population and low labor
force participation rates as evidence that the labor market is weak. I think
that is a difficult argument to make – see also
David Altig’s thoughts on this point.
There are likely secular trends in the labor markets that are not fully
accounted for yet. Another potential weak spot in the report was the flat work
week.

Overall, however, my take on the data suggests a relatively strong labor
market. In addition to steady job growth and low unemployment, wages gains are
accelerating, with January’s 7 cent gain pushing wages up 3.3% compared to last
year (and 2 consecutive 0.4% monthly gains, or an annualized 5.3% gain in
January). And buried within the data are further bright spots, such as a solid
decline in long term unemployment (more than 27 weeks):

Also, the unemployment rate including marginally attached persons and those
employed part time for economic reasons continued its steady march down as well:

Now, one does have to be careful with unemployment rates as they are lagging
indicators. But initial jobless claims – a leading indicator – remain low (in
Oregon claims have dropped to the lowest level in over 10 years). Moreover, I am
picking up anecdotal evidence that employers are sensing a change as well.
Paraphrasing one employer, “My employees are asking for higher wages, and
actually expecting they will get them. And they do.”

When employers complain about lack of potential workers, I tell them they
need to raise wages. This doesn’t make them happy, either.

Note that I am not attributing a stronger labor market to any specific
economic policies. And it is true that the labor market remained lackluster for
an extended period of time. But it does look like conditions have significantly
improved over the past year, and the Fed will take note. For a different view,
and another potential measurement problem, changes in the rates of
non-responders, see
Dean Baker at MaxSpeak.

In addition to the employment report, the bulk of this week’s data has also
been supportive of another rate hike. Productivity growth stumbled (see
David Altig) and unit labor costs
gained. I would be somewhat careful about overreacting to this report. The Q4
GDP report looked weak due to a number of factors that all came together at
once, but are probably not indicative of the underlying economic trend. This
would of course also apply to the productivity numbers. Still, the best days of
high productivity growth look behind us. The Fed will be wary that firms are
having an increasingly difficult time improving productivity, providing
additional incentive to push higher costs down the line.

The Institute of Supply
Management also provided its snapshot of manufacturing and non
manufacturing activity. In both cases, the outcome was slightly weaker than
expectations, but still suggestive that the economy remains on solid footing.
The details of the manufacturing report suggested the “resource utilization” in
growing – inventories were contracting, customer’s inventories were too low,
prices paid edged up, and the backlog of orders continued to grow. More meat to
feed the inflation hawks at the FOMC. But perhaps they will be softened somewhat
by the non manufacturing report, which indicated that inventories were too high.
Calculated Risk provides his thoughts and points out the
discontinuity of reports of a contracting construction industry with the
expansion in employment in that industry.

Two weeks ago I said that barring any
significant shifts in the bond markets, the Fed was ready to pull the trigger on
a complete inversion of the yield curve when policymaker’s pushed the overnight
rate to 4.5%. Since then, bonds have fallen substantially, with the 10 year rate
currently hovering around 4.55% (the curve is inverted at the 10 year – 2 year
horizon). A slim margin, to be sure, but a margin nonetheless.

Will longer term interest rates move up again? Or will the negative factors
waiting on the sidelines – the lagged impact of previous rate hikes, a softening
housing market, low saving rates, and possible consumer fatigue – turn against
us and put the FOMC firmly into pause mode? Many, I think would prefer to see
the Fed wait it out a meeting or two – see
Jim Hamilton, for instance. But the
steady, mostly supportive flow of data suggests not just yet, with the odds
still on the Fed will raise rates to 4.75% on March 28th.

Still, two months of data is a lot to chew on, and it is likely we will all
be scratching our heads between now and then. [All
Fed Watch posts.]